There are several banks that were affected Northern Rock in 2007 and in 2008 Bear Stearms collapsed. The 1980s United States loans and savings led to a credit crunch which is taken as a major reason in the US recession of 1990-1991. Speculative bubbles and crashes (Demyanyk and Van Hemert, 2008)
It is said that a financial asset exhibits a bubble when the price it is at now is greater than the present value of the income it will attain in the future, one gets this owning to maturity. An example of a financial asset is stock and an example of future income is interest or dividends. If the buyers who participate in the market buy the assets for the sole hopes of selling them later at a higher price, instead of simply buying them for the income it will generate, this is definitely shows that a bubble is present. When a bubble is present, and further more there is a peril of crash in the asset prices buyers will go on buying so long as they expect others to buy too, and so the time the majority of people want to sell, the value will go down. Really, it is hard to tell whether an assets price equals its real value, and hence it is not an easy job to detect bubbles (Demyanyk and Van Hemert, 2008).
Economists say bubbles occur very rarely if ever they do occur. Perfect examples of bubbles and crashes in stock prices are The Japanese property bubble, the deflating United States bubble, the dotcom bubble and also the Dutch tulip mania.
International financial crisesA country which maintains a fixed exchange rate when forced to devalue its currency since it feared a speculative attack, this is known as a currency crisis. When a country fails to give back its sovereign debt, it is known as a sovereign default. Devaluation and default could both be decisions of the government, but they are perceived to be involuntary results of a change in investor order which can lead to a sudden stop in the capital flows or even an increase in capital flight.There are examples of several incidences there are some currencies that summed up in the European exchange rate mechanism they suffered a crisis in 1992-93 and so were forced to devalue or simply back out from the mechanism. Also in 1997-1998, many Latin American countries defaulted due to their debt in the early 80s. Also the Financial crisis in the Russian government in 1998 led into a devaluation and as a result it led to a default.
Wider economic crisis
Negative Gross Domestic Products (GDP) that lasts two and more quarters is known as recession. A very prolonged recession is called a depression. And a long and slow period but not necessarily negative growth is known as economic stagnation.An example is the great depression, in which many countries there was bank runs and even stock market crashes. Also the sub-prime mortgages crisis and the bursting of some real estate bubbles all round the continent led to recession in the US and other countries in between the years 2000 and 2009.Background information of the global financial crisis (2000-2009) The global financial crisis has been the worst crisis in relation to the Great Depression that emerged in the 1930s. it attributed to the failure of major businesses, declines in the consumer wealth which was valued at more than billions of the US dollar, small financial commitments incurred by governments, and further a decline in the economic activities.Many causes have been suggested, with different weights assigned to each by economists. All kinds of solutions have been implemented or are being considered so as to be implemented.The fall of a global housing bubble, which was at peak in the United States in the year 2006, caused the values of securities attached to the prices of houses to plummet after this damaged financial institutions all over the world. There were questions dealing with bank solvency, reduction in credit availability, and very low investor confidence had a huge impact on global stock markets, which undergone large loses. All economies went slow worldwide during this period and in early 2009 as credit tightened a little and decline of international trade was experienced. Critics argued that credit rating agencies and respective investors had not succeeded to strike a balance between the price and mortgage related products, and also that the government did not adjust its regulatory movements to address twenty first century financial market issues.The causes of the crisis
The most obvious and immediate cause was the upward burst of the US Housing bubble which had a peak at around 2005-2006. Very high default rates were experienced on sub-prime and also Adjustable Rate Mortgages (ARM), started to increase very fast thereafter. An increase in loan negotiations such as easy initial terms and an abnormal long-term series of rising house pricing had made borrowers to presume that difficult mortgages in belief that they would in quick time be able to finance again at more convenient terms. But at the time interest rates began to shoot and house prices started to go down moderately in 2006 to 2007 in so many parts of the United States, refinancing was now harder than they thought. Defaults and foreclosure activities dramatically went up as easy initial terms expired, the home prices failed to shoot up as anticipated, and ARM rates of interest reset higher (Demyanyk and Van Hemert, 2008).In the years before and which went to the start of the crisis in2007, major amounts of money flowed into the United States from fast growing in oil producing countries and Asia as a whole. The inflow of money made it quite easy to keep interest rates in the US too low i.e. from 2002 to 2006, which attributed to easy credit conditions, leading to the US housing bubble. Loans off all types (e.g. credit card, mortgage, and even auto) were easy to get. Also as part of the booms (i.e. housing and credit), the amount of financial license called Mortgage Backed Securities (MBS) and Collterized Debt Obligations (CDO), which got their values from mortgage payments and even housing prices, this greatly went up. This kind of financial innovation made institutions and other investors all over the globe to invest in the Housing market of the United States. Major global financial institutions that had borrowed funds and invested in sub-prime MBS got big loses as the housing prices went down. Failing prices resulted also in houses worth less than the actual mortgage loan, making a financial incentive to get into foreclosure.
Still when the credit bubbles built, some of factors made the financial system to expand and become very fragile. Policymakers didnt realize the increasingly crucial role played by institutions dealing with finances like investment Banks and Hedge funds, they are also known as Shadow Banking System (SBS). Some economists believe that these financial institutions had become as vital as the Commercial depository banks in giving credit to the United States economy, but these didnt comply with the same rules.
These mighty institutions and also other banks which are regulated assumed major debt burdens while giving the loans and didnt have a good enough financial cover to accept big loan defaults. These defaults were similar to MBS loses, these loses forced the ability of financial institutions to give, slowing economic activity (Demyanyk and Van Hemert, 2008). Concerns of the stability of key financial institutions forced central banks to give money to facilitate lending and even further bring back faith in the paper markets that accustomed commercially, which are integral to giving funds to Business operations. The government bailed out major institutions and decided on implementing economic strategy programs, which needed a lot of financial commitments.
Growth of the Bubble
In between the years 1997-2006, the price of the normal American house increased by around 123. During the two decades coming to an end in 2001, the national median price of a home ranged from 2.9 to 3.2 times median household income. This ratio went up to 4.1 in 2004 and 4.7 in 2006. This housing bubble resulted in some owners of homes to finance again their homes at even lower rates, or simply financing consumer spending by seeing out mortgages the second time which is covered by the price appraisal.
In a certain award show, called Peaboy Award program, correspondents of NPR argued that a large pool of cash sought higher yields than those offered by the United States Treasury bonds early in the decade. More so, this pool of money had poorly doubled in size from around 2000 and 2007, still the supply of safe income generating investments hadnt become big that fast. . Investment banks on Wall Street tried to give an answer the demand using the MBS and CDO, which were given safe ratings by the credit rating agencies (CRA). In reality, Wall Street linked this large pool of money to the mortgage market, with very big fees coming up to all those in the chain of supply, from the many mortgage selling broker dealing with the loans to the very of small banks that actually did the funding to the broker, to the big investment banks behind them. By approximately around the year 2003, the supply dealing with mortgage started at traditional lending standards which had been already satisfied.
However, the very strong demand for CDO as well as MBS continued and started to drive down lending standards, so as the mortgages still could be sold together with supply chain. . Finally, this speculative bubble proved to be unsustainable.Easy credit conditionsRelatively Low interest rates encourage borrowing. From around 2000 and 2003, the federal funds by the Federal Reserve had lowered the rate targets from 6.4 to 1.1. The reason for this was to soften the results of the collapse of the dotcom bubble and the 11th month of 2001 attacks by terrorists, and also to fight the perceived risk of deflation (Woods, 2009).Also the pressure exerted on the interest rates was made by the U.S high and rising current account deficit, which took up together with the housing bubble in that year of 2006. Economists explained how trade deficits required the United States to borrow money from other countries, which bid up bond prices and made the interest rates low.They explained that between the years 1996 and 2004, the US current account deficit increased by almost 650 billion, from 1.5-5.8 of Gross Domestic Product (Woods, 2009). Giving funds to these deficits needed the US to be lent huge amounts of money from other nations a lot of the funds were mainly needed from countries with trade surpluses, and mostly from large economies that come from Asia and oil exporting countries. There is what is known as a balance of payments, and this identity needs that a nation having and operating a current account deficit must also have a capital account surplus of the same amount. Hence big and growing amounts of foreign funds flowed into the US to help finance its imports. This made demand for many types of financial assets, highering the prices of those assets while decreasing interest rates. Investors from other countries had some money to lend and this was simply because there personal savings rates was high or, or just because of high oil prices. They further referred to this as a saving glut. A flood of funds reached the US financial markets. Governments from other countries supplied funds by purchasing US Treasury bonds and so neglected a lot of the impacts of the crisis which were direct (Bernanke, 2007). US government used the money got from other countries to give finance consumption or to put up prices of some financial assets and housing. Institutions dealing with finances invested heavily on mortgage securities with their funds.
Sub-prime lendingas Woods (2009) explains the term sub-prime is used to refer to the quality of some borrowers credit, who has weak credit histories and a smaller risk of loan default than other major borrowers. The value of United States sub-prime mortgages was estimated at around 1.4 trillion as of February 2007, with over 7.6 million first-lien sub-prime mortgages outstanding (Demyanyk and Van Hemert, 2008). to add to the easy conditions of credit, it is known that all pressures from the government played a major role to increase the amount of sub-prime lending during the years before the crisis. Major United States banks and sponsored businesses by the government (Fannie Mae) played a major part in the expansion of higher risk lending.Predatory lending
Predatory lending refers to the act and use of unscrupulous lenders, to get into not safe secured loans for inappropriate purposes. A classic bait and switch method was introduced by nationwide marketing and advertising at quite low rates of interest for house re-financing. Those kinds of loans were written in contracts that were extensive, and switched with other loan products that were expensive on the actual day of closure. At times the advertisements would be stated as 2 or 1.8, still interest would be charged, here the buyer would be given an Adjustable Rate Mortgage also known as ARM- the interest charged is bigger than the paid interest amount (Demyanyk and Van Hemert, 2008). The credit consumer may not notice the amortization which was negative now but he may notice long after the loan transaction is over.
Deregulation
According to major critics, the regulatory framework did not match the innovations financially, just like the real need of Shadow Banking System (SBS), also the importance of off balance sheet financing. In some of the cases known, either the laws changed or the enforcement adjusted it in some parts of the system. Major examples includeIn 11th Oct, 1982, then the President (Reagan Ronald) decided to sign into law the Garn St Germain depository Institution Act, that started the process of Banking deregulation that assisted contribution in loans and savings crisis that occurred in the late 1980s and early 1990s crisis of finances of 20072009.
Woods (2009) asserts that in 1997, FED Chairman Alan Greenspan, fought to maintain the derivatives market unregulated. The Presidents working Group gave advice on financial markets, the United States head personnel, i.e. the president and congress just allowed the regulation of the over the counter (OTC) derivatives market that was when they put to act the commodity futures modernization Act of 2000. Some derivatives like credit default swaps-CDS are a time used to hedge against some various credit risks. The amount of credit default swaps outstanding moved to 100 fold from the years 1998 to 2008, with assumptions of the amount of debt covered by credit default swap contracts, that is as from December 2008, ranging from US34 to 48 trillion. The amount of OTC derivative value moved to 684 trillion by July 2008 (Woods, 2009).
Financial innovation and the complexity
Financial innovation is a term used to refer to the development of financial material set to make the clients happy, like offsetting various risk exposure or to help with getting finances. Good examples related to the crisis include ARM, the bundling of sub-prime mortgages into mortgage backed securities (MBS) or a times collateralized obligations (CDO) for resale to investors. The use of these products and more others really expanded in the years up to the crisis. These material products are different in ways of complexity and the way they can be estimated in terms of value using books of finance.
In accurate price of risk
Pricing of risks is the way compensation is required to be incremented by investors for having additional risks, this may be estimated by fees or other times using the interest rates. For many reasons, participants in the market didnt accurately measure of kinds of risks associated with financial innovation like MBS and CDO or get to know the impact on the whole stable condition of the financial system. Just an example, the way they price models for CDOs shows clearly that the risks level didnt show as they introduced it to the new system. There is the recovery rates average for high quality CDOs which is about 33 cents on the dollar, and the recovery rate for mezzanine using CDOs has been about 5 cents for a dollar. These big losses have made t0he balance sheets of banks all over the world making them have very small capital to keep on operating (Muolo and Padilla, 2008).
Commodity bubble
After the falling of the housing bubble, the commodity price bubble was created. The oil price was just about to triple from 55 to 145 from 2007 to 2008, just before the start of the crisis that took place in the late 2008. Economists have a strong debate on the actual causes which also include the flow of cash from investments like housing into other commodities to speculation and policies dealing with money or the increase feeling of material which is raw being scarce in economies that are growing fast. This makes those markets to have bigger participants like the increase of the Chinese in Africa. Also an increase in the prices of oil seems to make a larger share of consumers spend gas, this creates a pressure on the economic growth in the countries importing oil, and this makes wealth go to oil producing states.
Financial Markets Impacts Impacts on financial institutionsWoods (2009) explains that, the IMF estimated that the large United States plus the banks in Europe lost over 1.1 trillion in assets and also from bad loans from around January 2007 to around the eleventh month of 2009. The losses accrued are estimated to top 2.7 trillion from 2007-2010. The banks in the United States had an estimate of about 1.0 trillion losses and the European banks were estimated to reach about 1.7 trillion. The IMF estimated that United States banks were about 65 by their losses and the British Euro-zone banks were just 35 (Muolo and Padilla, 2008).
One of the victims was the Northern Rock, which was a British Bank. The very good nature of the business it did made it be able to request from the bank of England security. After being given, there was a bank run in the middle of September, 2007. Vince Cable who was then the chancellor of Liberal Democratic Shadow, made calls to make the institution to nationalize. These calls were ignored at first. And in February 2008, the government of Britain having not succeeded to get a private sector buyer, decided to relent and so the bank was in the hands of the public. The problems in Northern Rock were a clear indication of other similar problems to befall banks and other financial institutions later.
The very first time the kinds of companies affected were those that directly dealt with home construction and even mortgage finances such as Countrywide financial and Northern Rock, since they were not in a position to get finances via credit makers. Above 90 lenders of mortgages we re-known bankrupt in the period of 2007 and 2008. Bearing concerns and suggestions that investment Bank Bear Stearns would fall led to its fire sale to JP Morgan. The full height of the crisis was during the year of 2008 in the months of September and October.
There were some major institutions that were operational but acquired under duress or at times were under government takeover. These institutions were among others Lehman Brothers, Merrill Lycnch, Fannie Mae and even AIG.
Effects on the global economy Global effectsA group of experts have suggested that if the liquidity crisis keeps on, it is possible that an overlap of recession or worse is to happen. There were fears of doubt that the further development of the crisis could lead to a fall in the world economy. The crisis is most definitely going to have a huge effect on the banking industry since the loans and savings meltdown. The investment bank UBS clearly on October 6th 2008 stated that in this year there would be a global recession which could mean to recover it can take at least 2 and a quarter years.
The UK had begun an injection into the banking system, and the worlds central banks were having there interest rates to assist the borrowers. The type of bank injection is known as system injection and the UBS stressed that the US should implement such system. They further noted that the major advantage of implementing such a system is to solve the crisis.
In Iceland, the economic crisis had three banks at its involvement. Comparing to its economical size, the banking collapse is the biggest affected by any country in the whole of history.
Demyanyk and Van Hemert (2008) explain that, around the end of October, UBS had a brief look at the events the coming recession was to be seen as the very worst since 1981 and 1982 with downward growth of the economy in 2009 in US, Eurozone, UK and Canada. To recover it in 2010 will also be limited.
US Economic Crisis Effects
The GDP i.e. the Gross Domestic Product went down at an annual rate of about 5 in the last quarter of 2008 and even the very first quarter of 2009. The unemployment rate actually went up by 10.3 by the month of October 2009, this is the highest ever since 1983. the hours per work in a week ratio went down to about 35. This is also the lowest ever since the government started getting data in 1964 (Demyanyk and Van Hemert, 2008)
Responses to the crisis
Short-term and Emergency Responses
There are steps taken for the banks all over the world to expand there money supplies in order to overcome risks of a deflationary spiral- lower wage against higher unemployment rates. This would lead to a decline in global consumption.
The government has also enacted some fiscal packages by borrowing and spending to have away the reduction in the area driven by the private sector demand made by the economic crisis.
Woods (2009) explains that, the global financial system was about to collapse due to the credit freeze. The Federal reserve and other financial institutions were immediate and dramatic in responding to the calls of the crisis. Just around the last quarter of 2008, there are various financial institutions that purchased about 2.6 trillion of government debt. This was the largest monetary policy action in the world history. The governments in both European nations and US raised the capital of their bank systems nationally by about 1.7 trillion they bought newly issued preferred stock in the big banks.
Governments in a whole have played a good role in curbing the crisis as they have bailed out a good number of firms that were incurring large financial obligations. Up to now some United States government agencies have committed so much money in trillions of dollars in loans, asset purchase, guarantees etc.
Long-term responses
The president of the United States, Barrack Obama and other main advisers began number of regulatory proposals in the month of June 2009. These proposals address very key issues like consumer protection, bank financial cushion, executive pay, expanded regulation of the shadow banking system and enhanced authority for the Federal Reserve.
Also a number of regulatory changes have been proposed by experts in economy, politics, journalism, business and all kinds of leaders to make the impacts be as low as possible and the current crisis and even prevent it from ever recurring (Woods, 2009).
Some proposals of solutions were said and noted but have not been implemented. These include
Start resolution methods for closing financial institutions that have troubles in the shadow banking system like investment banks.
Regulate companies or institutions that are bank-like.
Institutions that are too big and may fail should be broken up.
All insolvent banks should be nationalized.
Minimum down payments for home mortgages of about 10 should be. Required.